Most Popular ArticlesAugust 18, 2009
PIMCO’s first two arguments – that inefficiencies exist in transaction costs and rebalancing – could be applied to virtually any fixed income ETF. But the TIPS market is far more liquid and efficient than virtually any other fixed income market, with the exception of the highly liquid nominal Treasury market.
The efficiency of the TIPS market is evident in the low tracking error for the TIP ETF. Until late last year, its average tracking error was between 0.04 and 0.06. In 2008, that figure rose to 0.53 because of liquidity issues stemming from the Lehman bankruptcy (see our article here for a further explanation of the volatility in the 2008 TIPS market), and the average tracking error this year has been 0.42. But these averages are still approximately half of the values for the LQD ETF, which tracks an index of the most liquid investment-grade bonds.
Perhaps the size of PIMCO’s portfolio, the experience of its trading staff, and the sophistication of its technology will allow them to capture a few basis points through these inefficiencies, but that’s all. The remaining alpha must generated through the auction and seasonality inefficiencies, which may be unique to the TIPS market.
As with the first two inefficiencies, I am willing to assume that PIMCO’s size and sophistication will enable it to capture some amount of alpha from these factors as well. But, unlike the first two efficiencies, any alpha these generate is unlikely to persist. If seasonal or auction factors create a large enough inefficiency for institutional investors to exploit, then PIMCO will quickly face competition and their advantage will be arbitraged away.
The authors acknowledge that passive management is best suited for markets with “an absence of active managers with records of long-term outperformance.” Vanguard is the only fund company to attempt a TIPS active fund, the Vanguard Inflation-Protected Securities – VIPSX.
That fund has failed to achieve long-term outperformance. It’s three-year and five-year returns trail those of TIP:
Fund |
3-year Return |
5-year Return |
VIPSX |
4.50 |
3.86 |
TIP |
4.84 |
4.04 |
Kenneth Volpert, head of Vanguard's taxable bond group, told the Wall Street Journal last week, "We feel that in the TIPS space active is a better way to go." His fund’s performance, however, offers no support for his statement.
In fairness, VIPSX is permitted to hold up to 20% of it assets in non-TIPS securities. According to Morningstar, as of its last quarterly report it held 14% in nominal Treasuries. Therefore, we cannot say whether a lack of opportunities in the TIPS market or a bad bet in the nominal market is the source of VIPSX’s underperformance.
The authors contend that, because the TIPS market has proportionately more passive investors, there are more opportunities for active managers. I believe the opposite may be the case: The smaller universe of actively managed TIPS means there are proportionately fewer opportunities to find mis-priced securities.
In fact, the authors make this point explicitly in the beginning of their paper, when they state that passive management is justified when there is “an absence of recurring structural risk premiums (a tightly arbitraged market).” Investors betting on a successful actively managed TIPS strategy are betting that the TIPS market contains exploitable risk premia.
TIPS may be volatile, but the TIPS market is well-understood easily modeled. Credit analysis is unnecessary and quantitative analysis should rapidly identify any inefficiency. Active management may succeed in the equity or corporate bond markets, where individual securities are highly differentiated and require shrewd analysis, experience, and judgment. Such is not the case with the TIPS market, where active management is doomed to fail.
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